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July 15, 2009

Leveraged ETFs

Approved for sale by the Securities and Exchange Commission in 2006, leveraged ETFs offer investors the ability to double and more recently triple the gains and losses experienced by many of the same market indices tracked by unleveraged ETFs. They are now some of the most actively traded securities in the United States, and sponsors are listing new funds constantly: in late June, Maryland-based ProFunds Group announced two new funds that give triple long and short exposure to the daily return of the Standard & Poor's 500. (Massachusetts-based Direxion and Maryland-based Rydex/SGI are the two other major sponsors of leveraged ETFs.)

As leveraged ETFs gain popularity, they have drawn increasing attention from the media and regulators for their extreme volatility--not to mention the unusual features that make them far different from unleveraged ETFs. The Financial Industry Regulatory Authority (FINRA) issued a Regulatory Notice in June reminding firms of the risks posed by leveraged ETFs, the obligation to understand their terms and features, and the need to determine whether they are suitable for each investor's financial situation.

Leveraged ETFs are designed and managed to provide exposure to the daily return of whatever index or security they track, a feature which is stated plainly in their promotional literature and regulatory filings, but whose full implications are not entirely obvious. Due to the effects of compound leveraging, the "daily return" over a period of more than one day is the cumulative result of a series of daily leveraged returns, and not the leveraged return of the index. That means that, over time, the performance of the leveraged ETF will diverge from the performance of the index the fund tracks. Severe losses can result for investors who fail to appreciate that divergence.

In a fund prospectus, Direxion provides an example of two $100 investments, one in a triple leveraged ETF and another in an unleveraged ETF based on the same index. If the index rises 5% one day, the triple leveraged ETF would rise to $115 and the unleveraged ETF to $105. If the index were to fall by 4.76% on the following day, the unleveraged ETF would return to $100, but the leveraged ETF would decline by 14.28% (triple the 4.76%), or $16.42, leaving an investment worth $98.58.

Over longer periods of time, or greater volatility, the difference is further magnified.

Direxion states in its prospectus that, over the course of a year, a fund using triple leverage for a long exposure to an index experiencing 20% volatility would lose 11% of its value even with no net change in the index, while a similar fund with a short position would drop by 21%. If the volatility were doubled to 40%, the losses would rise to 38% and 62% respectively, Direxion said.

Looking at the actual returns leveraged ETFs generate over time makes the point even more clearly. For the 12-month period ending May 31, 2009, ProShares Short Russell 2000 fund (RWM)--which offers the inverse (unleveraged) return of the Russell 2000 index--returned 9.02%, while the Ultrashort Russell 2000 fund (TWM)--which offers twice the inverse performance--recorded a 10.64% loss. For the year-to-date through the end of June, Direxion's Financial Bull 3X Shares fund (FAS)--which tracks the Russell 1000's Financial Services index and is one of the most actively traded issues in the United States--lost 63.17%. Direxion's Financial Bear 3X Fund (FAZ)--which offers triple the inverse return of the same index--fell by 87.14% over the same period.

Overall, the structure of leveraged ETFs means they make sense for use as a trading vehicle, and not as a "buy and hold" investment. Direxion's prospectus states in bold print that its funds "are designed as short-term trading vehicles for investors managing their portfolios on a daily basis. They are not intended to be used by, and are not appropriate for, investors who intend to hold positions in an attempt to generate returns through time."

Although most leveraged ETFs are quite new (and therefore do not have long-term performance data), Standard & Poor's has rankings on several (see table), since S&P's ETF rankings are not based solely on past performance. A quick word about S&P's methodology: instead of relying only on past performance and risk/return characteristics to generate a ranking, S&P also considers the outlook for the underlying holdings (stocks) within the ETF. Of course, S&P also weighs performance, costs, and risks.

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